Banking and Finance

Under the regulatory structures that had developed since the mid-nineteenth century, banks had dominated the financial scene, leaving the stock market and insurance companies to play secondary roles. Control over investment capital gave a few large banks great power. Distinct laws for each type of bank contributed to the development of a fragmented banking structure in which separate types of institutions served different purposes. Closely regulated by the central bank, the operations of which depended less on market mechanisms than on capital rationing, the traditional financial system served Finland's postwar reconstruction and industrialization well. This same system, however, appeared outdated in the dynamic international markets of the 1970s and the 1980s. As a consequence, a process of deregulation and internationalization was begun, which led to rapid changes in the financial sector. Observers expected further changes during the late 1980s and the early 1990s. In mid-1988 the process of liberalization was still incomplete, however, and many institutions retained their customary roles, making Finland's financial system a peculiar mixture of new and old.

Founded in 1811, the Bank of Finland (BOF) first provided the services of a true central bank in the 1890s. Formally independent, the BOF's management comprised bodies responsible to both the executive and the legislative branches of government. The governor and a board of directors, who were appointed by the president of Finland, controlled day-to-day operations. A nine- member supervisory council, named by and responsible to the Eduskunta, reviewed bank policy and made most fundamental decisions, especially those regarding monetary policy. The BOF served as the lender of last resort, and it regulated the currency and the financial markets. It also determined monetary policy and participated in the formulation of government economic strategies.

Although BOF policy originally had concentrated on maintaining the value of the currency, during the Great Depression of the 1930s the influence of Keynesian theories began to modify bank policies. After World War II, the BOF developed regulations designed to favor reconstruction and the development of manufacturing, and these remained in force almost unchanged throughout the 1960s. The regulations were part of a comprehensive government scheme for financial markets that included foreign-exchange restrictions, regulation of bank lending rates, a quota system for bank borrowing from the BOF, and an interbank agreement on deposit rates. At the heart of the system were tax rules that made interest earnings on bank deposits tax-free and interest charges paid by companies on loans fully deductible. These two measures combined to favor bank deposits and to facilitate debt financing for industry. The BOF used this panoply of regulations to hold borrowing rates artificially low--generally at negative real rates--to favor investment. As money markets were not in operation, the BOF resorted to distributing specific quotas of credits to commercial banks. Strict limits on the foreign-exchange market protected the system from international competition.

Besides the central bank, the banking system included a small number of commercial banks based in Helsinki, many local branches of cooperative and savings banks, and a small number of state- owned banks. The commercial banks differed from the others because they could borrow directly from the BOF, and they controlled most corporate banking. The networks of savings and cooperative banks primarily served households, which provided a solid deposit base. The split between the two banking networks was not absolute, however, as the savings banks and the cooperative banks had formed their own so-called central banks, which enjoyed commercial bank status.

Finland's commercial banks were the real leaders of the financial industry, and they controlled most lending to Finnish corporations. Although about ten banks were considered to be commercial banks, only two--the Suomen Yhdyspankki (Union Bank of Finland--UBF) and the Kansallis-Osake-Pankki (KOP)--were national banks with extensive branch networks. The four foreign-owned banks active in Finland also operated as commercial banks.

The cooperative and savings banks served a wide range of regional and local customers, but usually exercised relatively little economic power. They tended to specialize in providing home and farm banking services in rural areas. The savings banks were nonprofit banks designed to promote saving, and they served small-scale trade and industry as well as households.

Although private banks formed the backbone of Finland's financial structure, state-owned banks still accounted for about one-quarter of bank assets in the mid-1980s. The most important of these, the Postipankki, had about 40 branches of its own and made its services available at windows in more than 3,000 post offices throughout the country. Other state banks included the Industrialization Fund of Finland, Finnish Export Credit (partially owned by commercial banks and private industry), and the State Investment Fund and Regional Development Bank, both of which invested in underdeveloped regions and in industries with capital requirements that were too large for private firms.

Finland's commercial banks traditionally were allowed to hold as much as 20 percent of the total assets of Finnish corporations, and the leading banks had substantial holdings in the largest corporations. A 1987 law reduced the cap on bank ownership of corporate assets, but the banks' real power derived from their control over capital supplies. During the long postwar period of negative real interest rates, banks controlled the supply of capital--much of which was imported from abroad by the BOF. The two largest banks, KOP and UBF, built up rival spheres of influence that extended to many of Finland's largest industrial firms.

The crises and the restructuring of the late 1970s and the early 1980s provided the leading banks with further opportunities to strengthen their hold on Finnish industry. Starting in the late 1970s, KOP and UBF arranged many mergers among the wood- processing companies; by the mid-1980s, they had turned their attention to rationalization in the metal-processing industry. Several banks also engaged in takeover battles through the Helsinki Stock Exchange.

In the 1970s, several developments combined to reshape the operations of the postwar financial system. First, many corporations began to search for investment opportunities that offered both liquidity and higher rates of return than those offered for bank deposits. Second, as Finland shifted from importing capital to investing abroad, the old restrictions on foreign-exchange transactions became burdensome. Finally, a number of major Finnish corporations, having large shares of the domestic market, sought to expand abroad. Some, intent on foreign acquisitions, wanted to sell stocks on world exchanges in order to build assets sufficient for world-scale operations.

By the late 1970s, in response to the increasing internationalization of corporate life, the BOF management became convinced of the need to liberalize the regulatory system. The bank relaxed controls on borrowing abroad, and it allowed the establishment of an interbank money market; at the same time, the banks began to compete on interest rates for large deposits. These two developments caused Finnish interest rates in the corporate market to float up toward world levels, while the rates for most small depositors remained controlled. In 1982 the BOF allowed foreign-owned banks to open branches in Finland. In 1984 the BOF permitted Finnish banks to establish branches abroad, abolished bank-specific credit allocation, and began to levy identical reserve requirements on all banks. In 1987 legislation on bank deposits eliminated their traditional tax-free status. And in early 1988, the government proposed new banking laws that would put all major banks on the same legal footing.

The BOF had thus been willing to deregulate corporate banking partially, but important aspects of the regulatory system remained unchanged. The BOF continued to watch closely both foreign long-term borrowing and investments abroad by Finnish corporations. Retail banking continued much as before: small deposits placed at the regulated rates were tax-free, and the banks maintained their interest-rate cartel. The Finns had become accustomed to low and stable interest rates; proposals regarding interest were politically sensitive and might influence incomes agreements. Most observers thus expected that the BOF, ever cautious, would not rush toward further deregulation.

One effect of the liberalization of financial regulations and the internationalization of Finnish commercial life was the revival of the Helsinki Stock Exchange. Turning away from debt financing, more and more corporations issued stocks and bonds in the 1980s. Starting in 1982, the stock exchange attracted foreign investors, who accounted for about one-third of turnover in 1985. Younger, more prosperous Finns showed increased interest in stocks. As a result, although the market suffered a major slump in the second half of 1984, by late 1986 the stock index had increased tenfold compared with its 1980 level.

Incorporated in 1984, and almost immediately shaken by allegations of insider trading, the stock exchange in 1985 issued new regulations that were intended to increase the openness of its operations, thereby increasing its attractiveness for small investors. In 1987 the government reduced restrictions on foreign investors and passed a law allowing banks and insurance companies to set up mutual funds. In the fall of 1987, options exchanges opened, offering new instruments to stock traders. Also likely to enliven the market was legislation of the same year that eliminated the tax-free status of bank deposits. As Finnish equities continued to offer better rates of return than those on many markets, stock brokers had good reason to be optimistic.

Insurance companies, once marginal actors in capital markets, became Finland's largest institutional investors, after the establishment of compulsory insurance schemes in the early 1960s. After that time, insurance grew faster than the economy as a whole, and it contributed some 5 percent of GNP in the mid-1980s. As the result of restructuring in the early 1980s, there were about fifty insurance companies, associated in five large groups. The insurance companies placed about two-fifths of their investments in industry and an additional fifth in commerce. Other investments included other insurance firms and real estate.